HFMA Experts Speak: Credit Ratings & Debt Structure

HFA Partners' managing director Pierre Bogacz provides CFO advice for managing hospital credit ratings and debt structure in these economic times as well as shares some necessary best practices for successful mergers and/or acquisitions.

HFMA: Can you offer any best practices or procedures hospitals should be aware of in regards to managing their credit ratings and debts? Are you seeing many hospitals securing rating upgrades from S&P, Fitch or Moody's?

PB: The short answer is Yes and Yes. Let me start with the first question about best practices in terms of managing credit ratings and debt structure. The first best practice we recommend is for the Chief Financial Officer (CFO) to develop a good understanding of how debt impacts ratings, and vice versa. Ratings impact debt primarily in terms of cost of debt and access to the debt markets.

Most CFOs understand that typically, the more debt, the lower the rating. But to the rating agencies, not all debt is created equal. It pays to have a good discussion with somebody familiar with the rating process, such as a financial adviser, about debt structure, the rating process, debt capacity, and to understand what the rating agencies focus on. So the first best practice is to get up to speed on the process if you're not already familiar with it.

The second best practice, and a very important one, is for the hospital to have a plan on how to maintain or improve its rating. This is applicable regardless of whether the hospital is planning on issuing more debt, or staying at current leverage levels.

The reason why a plan is important is that the rating process is not just about financial performance, metrics, and ratios. It's also about qualitative factors, market position, who is management, how long they've been there, and what expectations are set and met with the rating agencies. The agencies are very much attuned to what they are promised versus what is delivered.

How well all of that is communicated to the rating agencies, how often, how responsive is the CFO, these are all qualitative things that people don't spend a whole lot of time thinking about but are very important. The other thing is that the hospital has to keep in mind is that their rating analyst probably also covers two or three dozen providers, and sometimes things get lost in the shuffle. It's up to the CFO to make sure that everything is communicated effectively.

The burden is on the CFO to make sure that the rating analysts have all the information they need, that they receive it on a timely basis, and in the process, that the CFO builds a personal rapport with the analysts. You've got an analyst that's pretty much going to be with you for the next two or three years or more. There is rotation involved, and it pays to meet the analyst face-to-face, preferably on their own turf in New York or over lunch or dinner, and make the business case for the rating the hospital wants, why they deserve it, and why now as opposed to two years down the road. This goes back to having a good understanding of how the agencies look at things.

And as far as rating upgrades, yes, we're seeing hospitals getting upgraded, and what's interesting is that in some situations, it's not just because of financial performance, but also because of how management has handled the process. The rating agencies tend to do what we call, "Rear-view mirror driving." They give more weight to what you've done, not what you're going to be doing. But if management is proactive and effective in communicating with the analysts and helping them get the full picture, the hospital has a better chance of being upgraded. There is no question that if performance deteriorates, a CFO could be the greatest communicator in the world but it's not going to help, but often times good news get discounted and ratings postponed because there isn't effective communications to start with.

So I think that the CFO needs to have an understanding of how the rating process works, and a clear plan. You also need the CEO and the Board to have bought into the plan as far as the rating agencies are concerned, and then you need to communicate the plan effectively, and of course deliver.

HFMA: How can hospitals prevent their portfolios from taking a hit in terms of bond rules and covenants?

PB: Well, bond covenants governing cash and liquidity are not generally restrictive as to how you invest so long as you have enough cash on on-hand. The three rating agencies (S&P, Fitch and Moodys), tend to prefer a hospital having more debt and more cash on hand, as opposed to less debt and not enough days cash on cash, because they look at how the hospital can service its debt. A bigger pile of cash on the balance sheet buys that much more time to weather hiccups in operating profitability and still make debt service payments. The rating agencies rate the hospital's ability to make debt service payments, not how well it is run.

As far as liquidity requirements, many bond issues have minimum days cash on hand requirements which depend on the rating category. That can be invested in any way the hospital chooses as long as it's liquid, meaning as far as the rating agencies are concerned, as long as it's unrestricted and the portfolio allocation is in relatively safer investments, as opposed to alternative investments such as real estate and hedge funds.

HFMA: Many hospitals are scaling back their capital projects, but how can they work to secure better bond ratings, and what are some other ways to secure credit or get capitals to make these projects happen?

PB: Hospitals are not too sure about exactly what healthcare reform is going to mean in terms of reimbursement, so the natural tendency is to cut or scale back projects. But as far as credit ratings are concerned, I think it's important for hospitals not to "run their business for the rating agencies". We tell clients that if they run their business for the benefit of the rating agencies, they'll end up with two piles: one pile of cash, because they wouldn't have spent anything on capital improvements and capital projects; the other pile will be rubbles, because their facility would have deteriorated for lack of maintenance and improvements for the sake of preserving cash and liquidity. So you can't run your business long-term and strategically based on what the rating agencies want.

Again, a rating is not a reflection of how well a hospital is run, whether you're doing the right thing in the marketplace, how well your quality of care ranks, etc. It's just an indication of how likely the bond holders are to be repaid. That's all it is. It's very much for the benefit of bondholders.

Now what a hospital can do to get better ratings, is to have a plan that takes into account whatever capital expenditures are on the horizon, any additional debt needed, and then build a business case with the rating agencies for why the hospital is going to be better off with that additional debt. And typically that's because it's going to produce a return on investment (ROI), which is something the rating agencies are very attuned to now, and they're not always getting it from the hospitals they're rating. The business case should be saying, "Okay, this is how much we're spending, and this is how much we expect to get back over time." And then they're free to dig into the specifics of that business case.

As a CFO, you don't want to assume that what makes sense to your Board is necessarily going to make sense to a rating analyst. The business case should include a presentation, back up information, and you should be prepared to argue your case and show the hospital has done its homework, this is one of the various alternatives, and it was determined to be the better one. That's one approach that we recommend.

The second approach is, start by taking a thorough look at your existing debt structure. The good news here is that as far as your existing debt is concerned, the rating agencies look at it the same way as a CFO ought to, and they ask: "Is this the optimal debt structure for what you're trying to accomplish? Does it minimize risk? Does it minimize the cost of borrowing?" I think any financial advisor worth their salt should want to take a fine comb through the debt structure, and do this beyond the traditional refunding opportunities.

You want to look at things like variable rate debt, swaps, anything that may put you at risk. In the case of variable rate debt, it could be put risk, letter of credit renewal risk. As we said, not all debt is created equal. Swaps are another area that has received a lot of attention lately. So just go down the debt structure and identify risk areas. The rating agencies will be going through the same exercise.

Not all debt is created equal, if you understand that, your current situation, and your balance sheet risk, you will be ahead of the game as far as how the rating agencies will evaluate you and any additional projects.

As far as where to get credit and capital, the problem, of course, with tax-exempt hospitals and any not-for-profit organizations is that the options are limited because there's no equity like on the for-profit side, and you can't get equity investors as a not-for-profit. So basically capital means debt, or you could argue, fund raising and any kind of philanthropy, but mostly debt. But debt can be a variety of things and doesn't have to be tax-exempt bonds. It can be bank debt. In fact, a lot of the variable rates, tax-exempt bond issues are being restructured as tax-exempt bank loans, such as bank qualified bonds. It can be equipment leases. It can be mortgages on individual properties. It can be private placements which don't all need to be rated to be sold. There are options if you don't have a rating or you don't want to get one, and there are all kinds of structures that pop up regularly.

A number of hospitals still haven't taken a look at what we call non-core assets, to see if they can monetize them to the extent that they're not critical to the hospital's mission. It could be a medical office building. It could be a lab. It could be anything that has value that there is no compelling reason for the hospital to directly own and which can be divested or leveraged to net some cash. You can do sale lease backs as well.

Some of the larger hospital and health systems have gone through that process several years ago, and now may not be the best time to monetize real estate because of what's going on with real estate in general, and commercial real estate, but it certainly is something that should be looked at, whether a hospital decides to go through with it or not.

The other way to access capital and you're not seeing that as much these days as back in the '90s, but some hospitals are looking at combining with other hospitals, most with an eye to improve their access to capital. You've probably read about the Caritas announcement in Massachusetts to sell to a private equity fund, announced a week or two ago. Most mergers are on a smaller scale, but many are done specifically to get access to capital because the hospital has a major project coming up, and it's unlikely they're going to be able to fund it, say, a replacement campus for an aging plant. The rating agencies like combinations, so long as they result in economies, because they find comfort in numbers. The bigger you are, the less likely you are to fail.

If you're a health system with three or four facilities, you're going to be rated based on slightly different standards than if you're a standalone hospital. The rating agencies generally don't stand in the way of these combinations particularly if there are cost savings involved, and that's another way to get access to capital. So the options are limited for not-for-profit hospitals, but oftentimes, CFOs overlook them. Instead they're thinking "Are we worthy of going out into the bond markets? If we're not ready or for whatever reason, we don't get a good enough of a deal, we're not going to look at anything else." That's a mistake.

HFMA: What are the top three things that need to be considered during a merger and acquisition that hospitals and organizations might not be aware of?

PB: Probably the same things that ought to be considered at the onset of getting into merger discussions, because the same requirements continue to apply throughout the process.

The first thing that you need to be aware of as a hospital, is that there's another organization at the table and you may not have the same goals. So understand what you bring to the table and try to put yourself in the other providers' shoes. Oftentimes what you think is value ends up being a liability for the other side, such as pet programs and academic programs that are valued very highly internally but turn out to be a liability for everybody else out there. So you've got to understand that. Future capital needs, which drive a lot of mergers, can also be a liability. So you should be aware of your strengths and weaknesses when you get to the negotiating table and may need a crash course in business valuation, understand how future cash flows get captured into fair market value because ultimately, that's what the consideration of the dollars involved boils down to.

The second thing is, keep in mind that regardless of what people tell you and maybe the other side tells you, mergers of equal do not work. There's just no way to have two cooks in the kitchen running the same business without stepping on each other's toes. So inevitably, one side is going to have to give up day-to-day control and you need to plan for that. That is the interesting part of the Caritas announcement, is that Caritas management is going to stay in place. That kind of flies in the face of 99% of the mergers and acquisitions that we've seen in the hospital business where in order to make it work, you've got to change things. Not to pick on Caritas or Cerberus, but there seems to be something missing there. Somebody has to give up day-to-day control. One of the sides involved has to give that up for it to work. A lot of the joint ventures back in the '90s were trying to do 50%/50% ownership joint ventures, or 51%/49%. The reality is that only one side is going to be running the combined entity, not two, so plan for that.

Another important thing is don't wait until the hospital has to do something to do it, because by then it's already too late from the standpoint of what to get out of it. The best time to negotiate is when you're in a position of strength. You haven't gone in the red. You still have some good profitability. What the valuation professionals out there call, "going-concern value" is driven by future cash flows. If you're in the red, you'd better have some valuable assets because somebody is going to have to make that up, either through cost savings or through "right sizing" as they say, a euphemism for getting rid of unnecessary operations. But you're going to have to make a case for how you will create value because you no longer are creating that value from cash flows. So don't wait until it's too late. Most of the smaller hospitals that end up selling to a for-profit do exactly that. They wait until there are no other options because politically it's very difficult to go to the Board and say, "We need to sell. That's our only option." Boards want to have no cash left on the balance sheet or be on the brink of bankruptcy before they're comfortable pulling the trigger. It's just not the right way to go.

We would like to offer a fourth item to the list: cultural differences are the top reason why mergers fail. All mergers, hospitals or otherwise. Cultural compatibility is sometimes hard to assess on the front end, but it's never too late to take a close look while you're still in negotiations. If cultures are not compatible, it's not going to go anywhere, so may as well save time and look at different partners, if you still can.